Global Market Volatility, Exchange Traded Funds and Hedge Funds

Global Market Volatility, Exchange Traded Funds and Hedge Funds

Global Market Volatility:

We thought it would be appropriate to book-end our August 22nd market piece sent to clients with a follow-up message after ‘the week that was.’ The trading range of most asset classes was much narrower on Friday (Aug 28th) than has been true over the last week. It goes without saying that the down-side volatility we observed in the earlier part of the week (and last Friday, August 21st) was long overdue. Then, on Thursday (Aug 27th), U.S. stocks closed sharply higher, as both the S&P 500 and Nasdaq Composite indices rose 2%, positive for the week. Oil prices rose more than 10% (their largest percentage gain in six years), and nearly all other commodities similarly rose. These indices only tell part of the story as global markets generally improved across-the-board after the market closed lower on Monday and Tuesday.

As we’ve noted, we do not believe there is a way of knowing whether this latest global bounce back seen at the end of the week is part of a broader bullish trend, or, if the correction we saw in the earlier part of the week, is the first in a series of corrections. We have been expecting (and, frankly, needing) a correction (defined as a 10% drop from market highs). In addition to bringing us to a correction from the May highs, the drop the previous Friday (Aug 21st) was the first 3% (or more) down day in over 4 years – a remarkable, extended bull run by historical standards.

The correction provided an excellent opportunity to proactively harvest tax losses (in taxable portfolios) and invest (or accelerate) cash phase-in strategies for those who had cash “on the side”. The tax losses harvested will provide a welcome offset to the capital gains that have accumulated since the market lows in 2009. For those who don’t have significant taxable portfolios (i.e. most of their capital is in retirement/401k/IRA accounts), tax loss harvesting is not a viable strategy. Still, accumulated cash can be deployed and portfolio rebalancing can be examined as market conditions merit. We appreciate our clients’ timely responses to our requests for trade approval as the window of opportunity was relatively narrow.

Exchange Traded Funds (ETFs)

While Pauley Financial’s investment philosophy has evolved over nearly 20 years, our firm has been steadfast since inception that disciplined, tax-aware rebalancing of a diversified portfolio (while keeping costs in check), is a cornerstone of our portfolio management approach to managing risk. I (Brian) was reminded of our commitment to the above-mentioned tactic (and of my career’s tracking of an industry trend) when I read a couple of articles in the Aug 1st edition of The Economist on Exchange Traded Funds (ETFs).

[Before I go into attributes and trends of these funds, I’d first like to pass along how I have come to trust The Economist as one of my primary new sources. While I was at JPMorgan, I was called back to active Army duty to serve in Baghdad – the story of how I came to join General George Casey’s special staff is too long to tell in this medium, but suffice it to say, one of my jobs was to track all media sources (something that the military calls information operations) and report their accuracy to the Commander of the entire theater of operations. I found the 24 hourly news sources (CNN, MSNBC, Fox) to have a very low correlation to reality, while the daily newspapers were nearly as bad. However, The Economist, a weekly publication, has ostensibly more time to check their facts and therefore was able to provide a refreshingly more accurate picture of reality. Their reporting of the world events that I was immersed in firsthand (as all organizations in the theater - military, civic, and non-governmental (NGO) - reported status to my staff daily so I was in a position to know), was head and shoulders above any other news source that I monitored during my year tour. ]

The August 1st edition of The Economist contains two articles which point out undeniable, industry trends, and underscore our firm’s adaptation of strategic asset allocation (with tax loss harvesting) using exchange traded funds (also known as ETFs). Anyone who has become a client of our firm has learned during a personal “investment class” how and why we employ these strategies. [As a reminder, ETFs are funds of securities, quoted on stock markets, which are designed to track a market benchmark (e.g., the S&P 500 index).]

Hedge Funds versus Exchange Traded Funds

Hedge funds invest across a wide range of asset classes, but take quite a different approach. Often using far more complicated strategies, hedge fund managers strive to offer a superior, risk-adjusted return. In other words, they aim to provide a more attractive balance between risk and reward. Because hedge funds can sell “short” (a bet on falling prices), their managers claim to prosper in both ‘up’ and ‘down’ markets. In exchange for what the industry refers to as “absolute return” (i.e. making money in up and down markets), these funds charge substantial fees (on average 2% of assets under management, and 15-20% of the upside performance). By comparison, ETFs charge, on average, 0.44%, and in most all cases are less than 1%. Said another way, hedge funds can be expensive (like a Ferrari), and have historically proven not to be reliable; whereas, ETFs have performed both smartly and reliably (like a Honda).

According to The Economist, in the 1990s, hedge funds enjoyed 7 years of double-digit average returns. In the first decade of the 2000s (when I worked for 2 different hedge fund groups), they managed just three such years. In the current decade, there has been just one year of double-digit returns. As noted in The Economist’s August 1st article, “Roaring Ahead”:

“Even when it comes to avoiding losses, the [hedge fund] industry’s record has deteriorated. There were no years of negative returns in the 1990s, but three since 2000. Hedge funds’ reputation took a hit in 2008, when they lost a lot of money. On a rolling five-year basis, their returns have been disappointing.”

In the interest of telling both sides of the story, there is a potential mismatch between the liquidity (sell-ability) of ETFs and the asset classes they own. The possibility does exist that this could delay or limit redemptions at a point of extreme market volatility. Accordingly, it’s important to invest in these asset classes for the long haul and to be proactive in setting aside capital to meet short and medium-term goals - a central part of Pauley Financial’s investment approach - without having to sell investments during inevitable market downturns.

In Summary

Today, the market seems to have embraced the value of ETFs. We have seen continued capital inflows to this humble, steady, and lower-cost investment vehicle. The value of investments in ETFs reached $2.971 trillion at the end of June 2015, $2 billion ahead of hedge funds’ $2.969 trillion, as calculated by Chicago-based Hedge Fund Research. Our firm has been at the forefront of this movement as a means to serve our clients in a more cost-effective, tax-efficient way.